[Managerial Economics Course/2018]

DEBRE TABOR UNIVERSITY

FACULTY OF BUSINESS AND ECONOMICS

DEPARTMENT OF MANAGEMENT

COURSE MODULE FOR THE COURSE MANAGERIAL ECONOMICS

Desalegn D.

Nov, 2022 E.C

P.O. BOX: 272
DEBRE TABOR, ETHIOPIA

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CHAPTER ONE

1. INTRODUCTION of MANAGERIAL ECONOMICS

Unit description
This chapter will cover the concepts of, managerial issues, decision making, scopes of managerial economics,
the nature of the firm, goals and constraints, the circular flow of economic activity & the concept of profits. To
assess students’ achievement, continuous assessments such as quiz, test, class activities, assignments and others
will be used.
Methods of delivery/teaching methods: Brainstorming, interactive lecture, group discussion, and independent
learning
Brainstorming

 Q. Explain and differentiate the following terms: managers, economics and

managerial economics.

1.1 Meaning of Managerial Economics

Managerial economics is the application of microeconomics to problems faced by the decision

makers in the private, public and not profit sectors. Managerial economics also defined as an
area of economics which deals with the application of economics theories, tools and logic in the
analysis business problem and decision making process of the firm, which affects its internal and
external (environment) areas. It is that guide which gives the manager the base for good
decision making.

1.2 The Scope of Managerial Economics

 Q. Explain the concepts of scope

The scope of managerial economics includes:

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Basically economics is divided into two broad categories, i.e. microeconomics and macroeconomics. Both
categories of theories are applicable to business analysis and decision making process of the firm. Directly or
indirectly, managerial economics comprises therefore of these areas of economics. The aspects of micro and
macroeconomics that constitutes managerial economics, depends on the purpose of the analysis.

1.3 The Nature of the Firm

 Q. Explain the reason why a firm is existed.

In order to earn profits, the firm organizes the factors of production to produce goods and services that will meet
the demands of individual consumers and other firms. The concept of the firm plays a central role in the theory
and practice of managerial economics.

In a free-market economy, the organization and interaction of producers (i.e. firms) and consumers is
accomplished through the price system. There is no need for any central direction by government. Within the
firm, transactions and the organization of productive factors are generally accomplished by the central control
of one or more managers. Thus, there is an apparent dichotomy in the organization of production in a market
economy. The price system guides the decentralized interaction among consumers and firms, whereas central
planning and control tend to guide the interaction within firms.

1.4 Goal and Constraints

 Q. Define what a goal and constraint mean?

The first step in making sound decisions is to have well defined goals because achieving different goals entails
making different decisions. The decision maker faces constraints that affect the ability to achieve a goal.
Optimal decisions are taken by the manager to minimize the constraints to maximize the goals.

The primary goal of the firm, namely:

Shareholder wealth maximization, is developed along with a discussion of how managerial

decisions influence shareholder wealth.
Separation of ownership and control and principal-agent relationships in large corporations are explored

Maximizing profit is a common long-term goal for new business owners or managers. However, you often
have to work through a number of constraints, some of these are:

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Supply Costs
Production Processes
Market Size
Demand
1.5 The circular flow of economic activity & The concept of profits

Figure: 1 Circular flow of income, output resources and factor payments

In economics, the terms circular flow of income or circular flow refer to a simple economic model which
describes the reciprocal circulation of income between producers and consumers. In the circular flow model, the
inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and
provide each other with factors in order to facilitate the flow of income.

Producers or business sector in return makes payments in the form of rent, wages, interest and profits to the
household sector. Again household sector spends this income to fulfill its wants in the form of consumption
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expenditure. Business sector supplies those goods and services produced and get income in return of it. Thus
expenditure of one sector becomes the income of the other and supply of goods and services by one section of
the community becomes demand for the other. This process is unending and forms the circular flow of income,
expenditure and production.

Concept of Profit

Economic profit is the amount by which total revenue exceeds total economic cost. The total economic cost is
the sum of the opportunity costs of each and every resource used by a firm. Businesses generally utilize two
kinds of resources;

1. Resources owned by others (such as labour services of skilled and unskilled workers, raw materials
purchased from commercial suppliers, and capital equipment rented or leased from equipment suppliers)
the opportunity cost of using resources owned by others is the dollar amount paid to the resource owners
are called explicit costs.
2. Resources owned by the firm(such as labour services provided to the firm by its owners, money
provided to the firm by its owners , money provided to the business by its owners, and any land,
buildings ,or capital equipment owned and use by the business). These costs of using a firm’s own
resources are called implicit costs since the firm makes no monetary payment to use its own resources.

Economic profit=Total Revenue-Total Economic Costs

= Total Revenue-Explicit Costs-Implicit Costs

Accounting profit is the difference between total revenue and explicit costs.
Accounting profit=Total Revenue-Explicit Costs

Example: suppose a firm has revenues of $5 million and explicit costs of $3 million. The owners of the firm
have provided$1 million of capital to the firm. If the owners could have earned a 10 percent return on the $1
million in their best alternative investment (of similar risk), the normal profit is $100,000. Economic profit is
$1.9 million (=$5 million-$3 million-$0.1 million).

Suppose this same firm receives total revenue of only $3.1 million, then the firm would be earning only a
normal profit, and economic profit is zero. Even though economic profit is zero, the owners are still “break
even” because the firm’s accounting profit of $0.1 million is just enough to pay the owners a normal profit for
the use of their resources.

Theories of Profit
Profit rates usually differ among firms in a given industry and even more widely among firms in different
industries. Some of the theories of profit are; Frictional theory of profit, risk bearing theory of profit,
monopoly theory of profit, managerial efficiency, and innovation theories of profit.

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Q. Explain the concept of the different theories of profit.

Refernce:
Lila J. Truett and Dale B. Truett (2001). Managerial Economics Analysis, Problems and Cases, 7 th
Ed, South-Western College Publishing
Paul G. Keatand Philip K.Y. Young (1996). Managerial Economics: Economic Tools for Today’s
Decision Makers, 2nd Ed, Prentice Hall, New Jersey

Discussion Questions
1. Identify and explain the factors that affecting firm’s profit maximization process
2. Discuss about the following terms:
Household
Firm
Factors of production

Exercises:
1. A recent engineering graduate turns down a job offer at $30,000 per year to start his own business. He
will invest $50,000 of his own money, which has been in a bank account earning 7 percent per year. He
also plans to use a building he owns that has been rented for $1500 per month. Revenue in the new
business during the first year was$107,000, while other expenses were

Advertising $5,000
Rent 10,000
Taxes 5,000
Employees salaries 40,000
Supplies 5,000
Prepare two income statements, one using traditional accounting approach and one using the opportunity cost
approach to determine profit.

2. At the beginning of the year, an audio engineer quit his job and gave up a salary of $175,000 per year in
order to start his own business, Sound Devices, Inc. the new company builds, installs and maintains
custom audio equipment for businesses that require high-quality audio system. A partial income
statement for Sound Devices, Inc. is shown below:

Revenues 2001

Revenue from sales of product and service $970,000

Operating costs and expenses

Cost of products and services sold 355,000

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Selling expenses 155,000

Administrative expenses 45,000
Total operating costs and expenses $555,000
Income from operations $ 415,000
Interest expense (bank loan) 45,000
Legal expenses to start business 28,000
Income taxes 165,000

Net income $177,000

To get started, the owner of Sound Devices spent $100,000 of his personal savings to pay for some of the
capital equipment used in the business. In 2001, the owner of sound Devices could have earned a 15 percent
return by investing in stocks of other new business with risk levels similar to the risk level at Sound Devices.

a) What are the total explicit, total implicit and total economic costs in 2001?
b) What are accounting profit, economic profit and normal profit in 2001?
c) Given your answer in part (b), evaluate the owner’s decision to leave his job to start Sound Devices.

CHAPTER Two

2. Fundamental Economic Concepts

Unit description

This chapter deals about the basic notion of equilibrium analysis marginal analysis, time value of money, consumer
reaction to their income, preference, price and other economic variable. To assess students’ achievement, continuous
assessment such as quiz, test, assignment, oral questions and others will be used.

Methods of delivery/teaching methods: Brainstorming, interactive lecture, group discussion, and independent
learning.
Fundamental economic concepts
Following are the fundamental economic concepts that provide cornerstones for all of the analysis in managerial
economics.
• Scarcity, Choice and Opportunity cost
• Marginal, Incremental and Equi-marginal principle
• Principle of the Time Perspective
• Time Value of Money
• Risk & Uncertainty

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Q. what do we mean by each of the above fundamental economic concepts?

2.1. Equilibrium Analysis

Brainstorming

 Q. Dear learner, could you define what equilibrium mean?

In many aspects of economic analysis, we tend to assume that a condition of equilibrium exists with respect to
key economic variables. Common examples include different models of market behavior known as Supply and
Demand analysis.
In these models of the market, we define the behavior of sellers based on the goal of profit maximization in the
production and/or sale of a particular good. Higher selling prices allow a trader/seller to reap a gain over and
above the price initially paid for a final good or asset. In the case of business firms, the production of additional
units of a particular good involve increasing opportunity costs in drawing resource inputs away from other
productive uses. Higher prices are necessary to cover these increasing costs of production. Thus, these types of
behaviors on the selling side of the market typically lead to a positive relationship between market price (the
dependent variable) and quantity supplied (the independent variable).
Separately, we define the behavior of buyers based on the goal of maximizing the utility gained from the
purchase and consumption of this same good. As prices fall, holding income constant, the buyer finds that
his/her purchasing power has increased allowing for buying greater quantities of a particular good.
2.2. Marginal Analysis

 Q. Explain the type of marginal analysis.

Marginal Analysis

The determination of optimal behavior by comparing benefits and costs at the margin, that is, benefits and costs
that result from small (i.e., marginal) changes. Optimality requires that marginal benefit equal marginal cost,
since otherwise a rise or fall could increase benefit more than cost.

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Marginal analysis is one of the most important managerial tools and it states that optimal managerial decisions
involve comparing the marginal benefits of a decision with the marginal costs (Baye, 2006). Therefore, two
important concepts marginal revenue and marginal cost is explained, respectively.

Marginal Revenue/Benefit

Marginal revenue is the extra revenue that an additional unit of product will bring a firm. It is expressed
mathematically as follow:

TR= P*Q

MR= ∆TR/∆Q
More formally, marginal revenue is equal to the change in total revenue over the change in quantity when the
change in quantity is equal to one unit (or the change in output in the bracket where the change in revenue has
occurred).
This can also be represented as a derivative. Total Revenue=Price*Quantity or TR=P*Q.

Marginal Cost

Marginal cost (MC) is refers to "the change in total costs arising from a change in the managerial control
variable" (Baye, 2006). Marginal cost is expressed mathematically as follow:

MC= ∆TC/∆Q

Marginal Analysis example as seen on

Marginal Costs:

Quantity Total Cost Marginal Cost

0
0 --

1
5 5

2
10 5

3
17 7

4
25 8
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5
34 9

6
44 10

Marginal Benefits:

Quantity Total benefit Marginal benefit

0 0 --

1 30 30

2 55 25

3 75 20

4 90 15

5 103 13

6 113 10

Substitution and Income Effects of Price change

Substitution effect : change in consumption ( demand )due to a change in its relative price, with the level of
utility held constant.

Income effect: change in consumption ( demand ) resulting from a change in real purchasing power , with
relative prices held constant.

N.B:
 The fundamental reasons for the existence of the law of Demand are the substitution & income
effects
The market equilibrium; Equilibrium of demand and supply
 How demand and supply strike a balance?
 How market attains equilibrium and how equilibrium price is determined in a free market?

Free market; free market is one in which market forces of demand and supply are free to take their own course
and there is no control on price demand and supply.

The concept of market equilibrium

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In physical sense, the term equilibrium means the state of rest. In general sense, it means balance in opposite
forces. In the context of market analysis, equilibrium refers to the state of market in which quantity demanded
of a commodity equals the quantity supplied of the commodity. The equality of demand and supply produces an
equilibrium price. At equilibrium price, demand and supply are in equilibrium. Equilibrium price is also known
as market clearing price. Market is cleared in the sense that there is no unsold stock and no unsupplied demand.
Equilibrium price is determined by integrating the demand and supply curves.

When a producer finds itself in disequilibrium, it has two choices: either adjust the price
to meet demand, or adjust output to meet demand. If adjustments are not made in a
timely manner, the firm will no longer be able to produce enough revenue to cover its
costs.
Discussion Questions:
1.. Net Benefits are maximized when:
A.) Marginal benefits equal marginal costs
B.) The slopes of the total benefits curve and total cost curve are equal.
C.) All the above.
D.) None of the above.
2. Marginal Analysis:
A.) Is the optimal managerial decisions involving comparing the marginal benefits with the marginal costs of a decision.
B.) Refers to the change in total benefits arising from the change in the managerial control variable.
C.) Refers to the change in total costs arising from a change in the managerial control variable.
D.) The additional revenues that stem from a yes-or-no decision.
3. Marginal analysis can be used:
A.) In determining how long to study for a test.
B.) In determining how to get to your spring break destination (i.e. plane=faster but more expensive, car=slower
but less expensive).
C.) In determining how much more to write on a wiki spaces page.
D.) All of the above.

2.3. The Time Value of Money

 Q. what is time value of money?

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The timing of money decisions involves a gap between the time when the costs of a project are borne, and time
when the benefits of the projects are received. It is important to recognize that $1 today is worth more than $1
received in the future. The manager must understand present value analysis.

2.4 Consumer Reaction to their income, preference, price and other economic
variable

 Q. Explain the different factor that affects consumer decisions?

Reduction in demand occurs when the quantities of a good or service demanded fall at each price. A variable
that can change the quantity of a good or service demanded at each price is called a demand shifter. When these
other variables change, the all-other-things-unchanged conditions behind the original demand curve no longer
hold. Although different goods and services will have different demand shifters, the demand shifters are likely
to include:
 Consumer preferences
 The prices of related goods and services,
 Income,
 Substitution effect
 Demographic characteristics, and
 Buyer expectations
Reference:

Lila J. Truett and Dale B. Truett (2001). Managerial Economics Analysis, Problems and Cases, 7 th
Ed, South-Western College Publishing
Paul G. Keat and Philip K.Y. Young (1996). Managerial Economics: Economic Tools for Today’s
Decision Makers, 2nd Ed, Prentice Hall, New Jersey
Discussion Questions

1. Discuss about the following terms:

 Consumer preferences
 Substitution effect
 Buyer expectations
 The quantity demanded
 A demand schedule

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Chapter Three Optimization Techniques

Unit description

This chapter deals concept of optimization techniques, types of optimization techniques, differential calculus and
optimization, partial differentiation and multivariate optimization constraint. To assess students’ achievement,
continuous assessment such as quiz, test, assignment, oral questions and others will be used.

Methods of delivery/teaching methods: Brainstorming, interactive lecture, group discussion, and independent
learning
Brainstorming

 Q. Dear learner, could you define what optimization mean?

3.1. Definition of Optimization

An act, process, or methodology of making something (as a design, system, or decision) as fully perfect,
functional, or effective as possible; specifically: the mathematical procedures (as finding the maximum of a
function). It also defined as the process of finding an alternative with the most cost effective or highest achievable
performance under the given constraints is refers to an optimization. The process of arriving at the best managerial
decision is the goal of economic optimization and the focus of managerial economics.

 Q. Identifies and explain the type of optimization technique.

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3.2. Types of Optimization Techniques

Optimization techniques are a powerful set of tools that are important in efficiently managing a firm’s
resources and thereby maximizing shareholder wealth.
An optimization can be:
Constrained optimization with Lagrange multipliers
Unconstrained optimization

Q. what is the difference between constrained and unconstrained optimization?

3.3 Partial Differentiation and Multivariate Optimization Constrained Langrage Multiplier

Technique

Optimization of multivariate functions

The conditions for relative maxima and minima for multivariate functions are very similar to those
for univariate functions, with one additional requirement.
First, all first-order partial derivatives must equal zero when evaluated at the same point, called a
critical point. If we are considering a function “z” with two independent variables x and y, then the
three-dimensional shape taken by the function z reaches a high or low point when evaluated at
specific values of x and y; these values are determined by setting the first derivatives equal to zero,
and then solving the resulting system of equations for the two variables.
Second, the second-order direct partial derivatives must both be the same sign when evaluated at
the critical point(s). For a maximum, they must both be negative and for a minimum, both
positive. This condition serves the same purpose as the second-order derivative condition in
univariate optimization. It guarantees that the point where the slope is zero is indeed a high point,
in the direction of the x variable and also in the direction of the y variable. This condition must be
satisfied for both variables simultaneously, in order to rule out shapes of functions such as "saddle
points."

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To understand a saddle point, imagine a three dimensional shape, at a point where in one direction
you are at the top of a hill (where the slope is zero), like being on a saddle where the shape is traced
from the left to the right of the saddle. Now, turn 90 degrees. You are still at a point where the
slope is zero, but the shape running from the back to the front of the saddle is now a valley and you
are at the minimum.
For this type of a shape, the first order derivatives of x and y are zero, but the second order
derivatives have different signs, meaning a relative maximum in one direction and a relative
minimum in the other.
The third condition is rather technical. When evaluated at the critical point(s), the product of the
second order partials must exceed the product of the cross partials. This condition rules out critical
points that are neither points of maximum or minimum, but are points of inflection. A point of
inflection is a point on a shape where certain conditions of optima are met, but the function does
not actually take on the shape of a maximum or minimum.
To sum up, the points of optimum must have all of the following characteristics:

Relative maximum Relative minimum

Let's try an example. Given the following function, start by setting first derivatives equal to zero:

Using the technique of solving simultaneous equations, find the values of x and y that constitute the
critical points.

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Now, take the second order direct partial derivatives, and evaluate them at the critical points.

Both second order derivatives are positive, so we can tentatively consider the function evaluated at
the critical point (x=1, y=1) to be a relative minimum. Now we take cross partials and check the
final condition:

Note that it wasn't necessary to take both cross partials. Recall that in a previous section we noted
that continuous functions will have identical cross partials. Therefore, either cross partial could
have been used in the last condition, but taking both is a good way to check your work.

Constrained optimization with Lagrange multipliers

Constrained optimization is the technique of optimizing a function while adding an additional limit
or constraint to the process. Typically, this constraint will be a budget (a monetary constraint) or
process limitation (a physical constraint). Up to this point, all optimization problems have
implicitly assumed that we could spend any amount of money on resources, and also use physically

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any amount of resources in order to optimize. This is one of the most unrealistic assumptions it is
possible to make, and so the last technique we will review is a technique that allows constraints to
be added to optimization processes.
The Lagrangian multiplier method incorporates a constraint into the body of the function being
optimized in such a way that only if the constraint is met will the function reach its optimal point.
Let's illustrate this with an example.
Suppose our goal is to optimize Z, subject to the requirement that x and y equal 60:

Now, we can take derivatives of L, with respect to x, y, and our new variable λ. The result of
forming this new function is that we have added the condition that in order for the derivative of L
with respect to the variable λ to be equal to zero (a condition of optimization), the coefficient on the
new variable must be equal to zero. Given the way the constraint is rearranged, the coefficient is
zero only when the constraint is met. Therefore, the process of optimization now includes meeting
the constraint as a condition of optimization.
Once the Lagrangian is formed, optimization is a very straightforward process. Take first
derivatives, set equal to zero, and use the three equations to solve for the two choice variables:

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The last step is to test whether the critical point is a maximum or minimum, using standard second
order conditions where second derivatives greater than zero implies a minimum, less than zero a
maximum.
Reference:

Lila J. Truett and Dale B. Truett (2001). Managerial Economics Analysis, Problems and Cases, 7 th
Ed, South-Western College Publishing
Paul G. Keat and Philip K.Y. Young (1996). Managerial Economics: Economic Tools for Today’s
Decision Makers, 2nd Ed, Prentice Hall, New Jersey
Thomas, J.W. (2003). Managerial Economics, theory and practice, academic press

Discussion Questions
1. Suppose the goal of the firm is to optimize its profit, subject to the requirement that x and y equal 50 and
the value of Z is equal to 4x2-2xy+5y2. Required, calculate the value of z using constrained optimization
technique.
2. Suppose that a firm’s profit function is given by the following relationship: π = -25 + 100Q1 + 95Q2 –
10Q12 – 5Q22 – 5Q1Q2 where Q1 and Q2 are the respective quantities of the two products that the firm
manufactures and sells. Each unit of the two products requires 10 and 5 units respectively of a certain
raw material. During the forthcoming period, the firm only has 50 unit of this raw material available to
produce the two products. The firm desires to maximize profits subject to the raw materials constraint.
(a) Formulate the problem in a programming framework.

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(b) Solve the problem using Lagrangian Multiplier techniques. What are the optimal quantities
(Q1 and Q2) of the two products?

3. Suppose that the manager of a firm is planning to meet an order of 1000 units of two products X and Y.
the manager’s problem is to find the combination of two goods that minimize its cost. He has the firms
cost function of two goods estimated as C=5x2+20y2
By using the Lagrangian multiplier method, find the quantity of X and quantity of Y, subject to X
+Y=1000, that minimize the cost of meeting the order.

Chapter Four Demand and Demand Forecasting

Unit description
This chapter deals with definition of demand, analysis of market demand, demand function and elasticity of
demand and its application. To assess students’ achievement, continuous assessments such as quiz, test, class
activities, assignments and others will be used.

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Methods of delivery/teaching methods: Brainstorming, interactive lecture, group discussion, and independent
learning.
4.1. Introduction

Brainstorming

 Q. Dear learner, could you define what quantity demanded mean?

The term demand refers to the various amounts of goods and services someone (a single consumer or a group of
buyers)is both willing and able to buy at various possible prices.

4.2. Individual and market demand

Individual demand can be defined as the quantity of a commodity that a person is willing to buy at a given price
over a specified period of time. Say per day, per week, per month etc. While market demand, refers to the total
quantity that all users of a commodity are willing to buy at a given price over a specified period of time. In fact,
market demand is the sum of individual demands.

Market demand refers to the quantities of goods and service that the people are ready to buy at various prices
with in some given time period, other factors besides price held constant.

 Q. List and explain the determinants of demand.

4.3. Demand Function

A demand function states how each of a number of relevant variables affects the amount of goods or services
consumers will buy during some time period. The demand function for a firm’s product relates the quantities of
a product that the consumer would like to buy during some specific period to the variables that influence a
consumer’s decision to buy or not to buy the good. Such often include the price of the product, the price of
other related goods, consumers’ income, the season of the year and dollars spent on advertising. For example
the quantity of a particular brand (Brand X) of up market microwave oven purchased by consumers during a
year may be a function of a price of the oven, the price of competing brand of oven, the number of women who
works outside the home, consumer annual disposable income and dollars spent yearly on advertising.
Therefore, the demand function can be represented mathematically as follow: Qx= f(Px, Py, F,IA),

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Where Qx = represents quantity demanded per year of brand X

Px = the price of brand X

Py = the price of brand Y

F = the number of women who are employed

I = the average annual per capita disposable income and,

A = the dollars spent per year on advertising

For example, assume our hypothetical demand function for Brand X microwave ovens purchased per year had
the following specific relationship:

Qx= 26,500-100Px + 25Py + 0.0001F + 1.3 I + 0.02A and that Px= $400, Py= $ 500, F= 40,000,000, I=
$20,000, and A= $ 50,000 solving for Qx (the number of Brand X microwave ovens purchased per year), by
letting the independent variable take on these values, we find that

Qx= 26,500 - 40,000 + 12,500 + 4,000 +26,000+1000

= 30,000 ovens per year

If all of the independent variables remain at the values just stated, the firm will sell 30,000 microwave ovens per
year.

4.4 Elasticity of Demand and Its Application

In this content, we will discuss how sensitive the change in quantity demanded is to a change in price .the
measurement of this sensitivity in percentage terms is called the price elasticity of demand. Elasticity is
expressed mathematically as follow:

Coefficient of elasticity = Percentage change in A

Percentage change in B
The result of this division is the coefficient of elasticity. Therefore, the task is to interpret the coefficient and to
determine the effect of the change. The meaning of the size and the sign of the coefficient may be negative or
positive)

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 Q. Explain the price elasticity of demand.

4.5 Demand Forecasting

Q. Explain demand forecasting?

Q. Why is it so important in the management of business firms and other enterprises?
The aim of economic forecasting is to reduce the risk or uncertainty that the firm faces in its short-term
operational decision making and in planning for its long-term growth.
Demand forecasting is a specific type of business forecasting. It is a forward projection of data variables.
The objectives of forecasting are; to predict demand, to determine the possible market share, estimate industrial sales
growth, probable areas of expansion, information on proper product mix. Major decisions in large businesses are based n
forecasts of some type.

Techniques of demand forecasting

The technique used in any specific instance depends on a number of factors, including the following:
1. The cost associated with developing the forecasting model compared with potential gains resulting from its
use
2. The complexity of the relationships that are being forecast
3. The time period of the forecast (long-term or short-term)
4. The accuracy required of the model
5. The lead time necessary for making decisions dependent on the variables estimated in the forecast model

There are two types of demand forecasting techniques. These are qualitative and quantitative demand
forecasting techniques.

 Qualitative forecasting technique

An intuitive judgmental approach to forecasting can be useful if it allows for the systematic collection and
organization of data derived from unbiased, informed opinion. However, qualitative methods can produce
biased results when specific individuals dominate the forecasting process through reputation, force of
personality, or strategic position within the organization.
Consumer Survey Techniques - The rationale for forecasting based on surveys of economic intentions is
that many economic decisions are made well in advance of actual expenditures.

Expert’s opinion-The most basic form of qualitative analysis forecasting is personal insight, in which an
informed individual uses personal or company experience as a basis for developing future expectations.
Although this approach is subjective, the reasoned judgment of informed individuals often provides valuable
insight.

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When the informed opinion of several individuals is relied on, the approach is called forecasting through panel
consensus. The panel consensus method assumes that several experts can arrive at forecasts that are superior to
those that individuals generate.
Delphi method has been developed to counter forceful personality of dominance key individuals. In the Delphi
method, members of a panel of experts individually receive a series of questions relating to the underlying
forecasting problem. Responses are analyzed by an independent party, who then tries to elicit a consensus
opinion by providing feedback to panel members in a manner that prevents direct identification of individual
positions.
Market Experiments

To set up a market experiment, the form selects a test market. This market many consist of several cities, a region of the
country, or a sample of consumers taking from a mailing list. Once the market has been selected, the experiment may
incorporate a number of features. It may involve evaluating consumer perceptions of a new product in the test market. In
other cases, different prices for an existing product might be set in various cities in order to determine demand elasticity.
A third possibility would be a test of consumer reaction to a new advertising campaign.

Q. What are qualitative forecasts? What are the most important forms of qualitative forecasts? What
is their rationale and usefulness?

 Quantitative forecasting techniques:

Time-series analysis: it attempts to forecast future values of the time series by examining past
observations of the data only. Time-series data refers to the values of a variable arranged chronologically by
days, weeks, months, quarters, or years.
Secular trend, cyclical fluctuations, seasonal variations, and random fluctuations are reasons for fluctuations in
time series data.
Trend analysis is based on the premise that economic performance follows an established pattern and
that historical data can be used to predict future business activity
Smoothing- Other methods of naive forecasting are smoothing techniques. These predict values of a
time series on the basis of some average of its past values only. Smoothing techniques are useful when the time
series exhibit little trend or seasonal variations but a great deal of irregular or random variation. There are two
smoothing techniques: moving averages (the forecasted value of a time series in a given period (month, quarter,
year, etc.) is equal to the average value of the time series in a number of previous periods.), and exponential
smoothing (It is a technique of time series that gives greater weight to more recent observations).

Thus, the value of the forecast of the time series in period t + 1 is Ft+1 = wAt + (1 – w) Ft). Where;

Ft+1: forecasted demand for the next period (t+1)

W: the desired response rate (smoothing constant)
At: actual demand for period t

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Ft: forecasted demand for period t

Barometric forecasting

Leading indicators can be used to forecast changes in general economic conditions. The use of such indicators is
commonly referred to us barometric forecasting.

A time series that is correlated with another time series is called an indicator of the second time series. Substantial time
and effort have been expended searching for good indicators of economic trends. By observing changes in the second
series, it may be possible to predict changes in the first, by correlating it. These data are closely followed by economist,
managers, and financial analysts.

If two series of data frequently increase or decrease at the same time, one series may be regarded as a coincident
indicator of the other.

If changes in one series consistently occur prior to changes in other series, a leading indicator has been identified.

Composite and diffusion indices for barometric forecasting

A composite index is a weighted average of individual indicators. The weights are based on predictive ability of each
series.
Diffusion index is a measure of the proportion of the individual time series that increase from one month to the next.
Example: Following are data for three leading indicators for a three month period. The first month represents the base
period, and the three series are to be given equal weight. Construct a composite and diffusion index from the data.

Month leading indicator leading indicator II leading indicator III

1 400 30 100
2 425 29 110
3 460 33 135
Solution:
The diffusion index:

It is generated by determining whether each series increased or decreased from month to month. For the second month,
series I and III increased, but series II decreased. Hence the index is 66.7 for that month. During the third month, all the
series increased in comparison to month 2. Thus the index for that month is 100.

Composite index:

It can be computed by first calculating the percentage changes (relative to the base month) for each series. Percentage
series during the second month were 6.25 percent for the first series,-3.33 percent for the second, and 10 percent for the
third. Giving each series equal weight, the average percentage change from was 4.33 percent (6.25+-3.33+10/3=4.33).
The value of the composite index for the first month is arbitrarily set to 100, so the index for the second month is 104.33.

For the third month, the changes from the base period are 60/400=15 percent,3/30=10 percent, and 35/1100=35 percent,
respectively.

Thus the average value change is 20 percent. Hence the index for that month is 120.
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Values for the two indices for each month are shown in the following table. Both indices suggest that economic conditions
should improve in future months.

Month diffusion index composite index

1 - 100

2 66.7 104.33

3 100 120

Exercise
Direction: Based on the following historical data attempt the required questions.
The following historical data is obtained from a certain firm.
Year Actual demand in units
1 400
2 380
3 430
4 450
5

Required
a) Determine the 5th year’s demand using last period demand method.
b) Determine the 5th year’s demand using arithmetic mean.
c) Determine the 5th year’s demand using simple three years moving average.
d) Determine the 5th year’s demand using weighted moving average method using the following weights: 0.40,
0.30, 0.15 and 0.05.
e) Determine the 5th year’s demand using exponential smoothing method assuming that the forecast demand
for the 4th month was 440 units and the smoothing factor is 0.10.
Reference:
Lila J. Truett and Dale B. Truett (2001). Managerial Economics Analysis, Problems and Cases, 7 th
Ed, South-Western College Publishing
Paul G. Keat and Philip K.Y. Young (1996). Managerial Economics: Economic Tools for Today’s
Decision Makers, 2nd Ed, Prentice Hall, New Jersey
Thomas, J.W. (2003). Managerial Economics, theory and practice, academic press
Nick, W. (2005). Managerial Economics, A problem solving approach, Cambridge University
press, New York
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Chapter Five: Decision Making Under Risk and Uncertainty

This chapter deals with the nature of decision making; meaning and measurement of risk, decision making
approaches and decision making conditions. To assess students’ achievement, continuous assessments such as
quiz, test, class activities, assignments and others will be used.

Methods of delivery/teaching methods: Brainstorming, interactive lecture, group discussion, and independent
learning

Brainstorming
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 Q. Dear learner, could state the base what makes risk, certainty and uncertainty decision making?

5.1. The Nature of Decision Making

In economic or financial theory, the two terms risk and uncertainty have somewhat different meanings, even
though they are used interchangeably. Although no future events are known with certainty, some events can be
assigned with probability and others cannot. Where future events can be defined and a probability assigned is
for risk and the events which cannot be defined and assigned probability is uncertainty.

 Q. Identify and explain the sources of risk

5.2 Meaning and Measurement of Risk

When two outcomes are uncertain, two measures that take risk into consideration are used. First, not just one
outcome but a number of outcomes is possible. Each potential result will have a probability attached to it. A
probability distribution describes, in percentages terms, the chance of all possible occurrences. When all the
probabilities of the possible events are added up they must total 1, because all possibilities together must equal
certainty. Therefore, once we have established a probability distribution, we are ready to calculate the two
measures used in decision making under conditions of risk. So we can calculate by using:

 Expected value
 Standard deviation
 Discrete Vs Continuous distribution and the
normal curve
 The coefficient of variation

 Q. Explain the above terms.

5.3. Approaches of incorporating Risk into Decision Making Process

Up to the point, two measures have been used in connection with the evaluation of risk. The first was the
expected value or the expected net present value of a project spanning a period of time. The second was the
standard deviation, which represents a gauge of the extent of the risk. Given these two yardsticks, the decision
maker has to determine whether the profitability of a project is sufficient to offset the risk of involved. The two
other technique of accounting for risk is commonly used. Both of these make the risk adjustment within the

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present value calculation, so that the final result is just one number: the net present value adjusted for risk. The
two methods are:

The risk adjusted discount rate (RADR), in which the risk adjustment is made in the denominator of the
present value calculation.
The certainty equivalent, in which the numerator of the present value calculation is adjusted for risk.

 Q. Discuss the about risk adjusted discount rate.

5.4 Decision Making Under Uncertainty

Uncertainty is a consequence of the unknown sign of random effects and limits to corrections for systematic
effects and is therefore expressed as a quantity, i.e an interval about the result. It is evaluated by combining a
number of uncertainty components. The components are quantified either by evaluation of the results of several
repeated measurements or by estimation based on data from records, previous measurements, knowledge of the
equipment and experience of the measurement.
In most cases, repeated measurement results are distributed about the average in the familiar bell-shaped curve
or normal distribution, in which there is a greater probability that the value lies closer to the mean than to the
extremes. The evaluation from repeated measurements is done by applying a relatively simple mathematical
formula. This is derived from statistical theory and the parameter that is determined is the standard deviation.
Uncertainty is an unavoidable part of any measurement and it starts to matter when results are close to a
specified limit. A proper evaluation of uncertainty is good professional practice and can provide laboratories
and customers with valuable information about the quality and reliability of the result. Although common
practice in calibration, there is some way to go with expression of uncertainty in testing, but there is growing
activity in the area and, in time, uncertainty statements will be the norm.
Chapter Six: Production and Cost Analysis
This chapter deals with material theory of production and theory of cost, economies and diseconomies of scale
and economies of [Link] assess students’ achievement, continuous assessments such as quiz, test, class
activities, assignments and others will be used.

Methods of delivery/teaching methods: Brainstorming, interactive lecture, group discussion, and independent
learning
Brainstorming

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 Q. Dear learner, could you define what production and cost mean?

6.1. Theory of Production and Theory of Cost

6.1.1. Theory of Production
The basic function of the firm is that of readying and presenting a commodity or service for sale –presumably at
a profit. When the firm’s activities center around a tangible product rather than service, the firm may merely
obtain the item from another enterprises and sell it to a third party, or it may also undertake the partial or
complete (from raw material) manufacture of that item. We will use the term production in broad sense
referring to all of the procedures that the firm may go through to present its good or services for sale. So in this
part, we will see how a firm’s manager can use economic principles to ensure that its product is produced at the
lowest possible cost, given a certain desired level of output. Production can be categorized into long run and
short run time period. Long run is distinguished from the short run by being a period of time long enough for all
inputs, or factor of production, to be variable as far as an individual firm is concerned. The short run on the
other hand, is a period so brief that the amount of at least one input is fixed. Certainly the length of the time
necessary for all inputs to be variable may differ according to the nature of the industry and the structure of the
firm. In practical sense, economists think of the long run as a planning period involving decisions regarding
investment in new plant and equipment, while the short run involves operations from existing plant and
equipment.

[Link] The Production Function

The production function can be defined as the relationship between
productive inputs and outputs of a product per unit of time. In
mathematical term:
Q=f(X1, X2, …Xk) …………………..(6.1)
Where
Q= output
X1, …Xk= inputs used in the production process

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We assume that the relationship between inputs and outputs exists for a
specific period of time. In other words, Q is not a measure of output
accumulated over time. There are two other key assumptions that you
should be aware o. First, we are assuming some given “state of the art” in
the production technology. Any innovation in production (e.g., the use of
robotics in manufacturing or a more efficient software package for
financial analysis) would cause the relationship between given inputs and
their output to change. The second, we are assuming that whatever inputs
or input combinations are included in a particular function, the output
resulting from their utilization is the maximum level. With this in mind we
can offer a more complete definition of a production function:
A production function defines as the relationship between the inputs and
the maximum amount that can be produced within a given period of time
with a given level of technology. For the purpose of analysis, let us reduce
the whole array of inputs in the production function to two, X and Y.
restating equation (6.1) given us
Q= f( X,Y) …………………..(6.2)
Where
Q= output
X= Labor
Y= Capital
Notice that although we have designated one variable as labor and the
other as capital, we have elected to keep the all purpose symbols X and Y
as a reminder that ant two inputs could have been selected to represent
the array of inputs.
As stated earlier, in economics analysis the distinction between the short
run and the long run is not related to any particular measurement of time
( days, months, years). Instead it refers to the extent to which a firm can
vary the amounts of inputs in its production process. If there is insufficient
time for the firm to adjust the amount of time to vary all the inputs is
considered the long run, however, long run or short run this actually is in
calendar time.

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Short run analysis of total, average and marginal product:

First economists use a number of alternative terms in reference to inputs
and outputs:
Inputs Outputs
Factors Quantity (Q)
Factor of production Total product (TP)
Resources Product
Second, in the short run analysis of the production, two other terms
besides the quantity of output are important measures of the outcome.
They are marginal products (MP) and average product (AP). If we assume x
to be the variable inputs, then
Marginal products of X= MPx= ∆Q/∆X, holding Y constant
The average product of X= APx= Q/Xholding Y constant
In other words, the marginal product can be defined as the change in
output or total product resulting from a unit change in variable input, and
the average products can be defined as the total product per unit of inputs
used.
Production function using long run:
The production function expressed the relationship between the output and
one more inputs. The output is referred to either as total product (TP) and
Q (quantity). So the production function generally takes the general form:
Q= f (L, K)
Where Q= Quantity of output
L= Labor (i.e. the variable input)
K= Capital (i.e. the fixed input)

6.1.2. Theory of Cost

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. Cost is considered to be relevant if its incurrence has an impact on the alternatives being considered in
business decision. In deciding whether a cost actually has an impact on the options available to the decision
makers, the following distinctions should be kept in mind. A cost can be:
 Historical cost Vs replacement cost
 Opportunity cost Vs out-of –pocket cost
 Sunk Vs incremental cost
Costs can be calculated by using:

TC= TFC+ TVC

AC= AFC + AVC (or TC/Q)

MC= ∆TC/∆Q (or ∆TVC/∆Q)

AFC= TFC/Q

AVC= TVC/Q

6.2 Economies and Diseconomies of scale

If a firm’s long run average cost declines as output increase, the firm said to be experiencing economies of
scale. If long run average cost increases, economists consider being a sign of diseconomies of scale. There is no
special tern term to describe the situation in which a firm’s long run average cost remains constant as output
increase or decrease.

 Q. Explain the above terms?

6.3. Economies of scope

Economies of scope refer to the reduction of a firm’s unit cost by producing two or more goods or services
jointly rather than separately. In a sense economy of scope closely related to economies of scale. Engaging in
more than one line of business may require a firm to have a certain minimum scale of operation. In other words
to view the relationship between scale and scope is to consider that the company’s expansion into different
business naturally increase its scale of operation.
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Reference:
Lila J. Truett and Dale B. Truett (2001). Managerial Economics Analysis, Problems and Cases, 7 th
Ed, South-Western College Publishing
Paul G. Keat and Philip K.Y. Young (1996). Managerial Economics: Economic Tools for Today’s
Decision Makers, 2nd Ed, Prentice Hall, New Jersey

Chapter Seven: Pricing Strategies and Practices

This chapter deals with meaning of pricing and pricing approaches. To assess students’ achievement,
continuous assessments such as quiz, test, class activities, assignments and others will be used.

Methods of delivery/teaching methods: Brainstorming, interactive lecture, group discussion, and independent
learning
Brainstorming

 Q. Dear learner, could you define what price mean?

7.1. Introduction
One of the critical decisions made by a manager for the success of a firm is setting the price of output. The
effect of pricing choices is reflected in short run profits. Pricing decisions are a major factor in determining a
firm’s long term success or failure. If the firm has control over price, the rule is to produce until marginal
revenue equals marginal cost and charge the price indicated by the demand curve for that quantity. This section
discusses a broader perspective for pricing decisions- firms with multiple products and considers both demand
and production interdependencies, price discrimination, product bundling, peak load pricing, cost plus or mark
up pricing.

 Q. Explain what strategy mean

7.2 Pricing Strategies

Pricing of multiple goods

Some of the products are unrelated. For example, the demand for Pringle’s Potato Chips is unlikely to be
affected by the price of Tide. Similarly, production costs of Pringle’s are independent of the amount of Tide
produced. Proctor & Gamble brands, Luvs and Pampers would be considered substitutes by consumers of
disposable diapers. The price of Luvs affects the demand for Pampers and vice versa. Also the two competing

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brands share the same production facilities. Then if pricing decisions are based partially on costs, prices will be
dependent on how costs are allocated between the two products.

Products with interdependent demands

Products with interdependent demands are either substitutes or complements. For substitutes, such as Luvs and
Pampers, a price increase for one good tends to increase the demand for the other. For goods that are
complements, a price increase tends to reduce the demand for the other good. Sales of antilock brakes, power
windows, and stereo systems by an automobile manufacturer are dependent on the number of vehicles sold by
the company.

When demands are interrelated, managerial decisions are taken by considering the marginal revenue equations
for the products. Consider a firm that produces only two goods X and Y. Assume that the sales of ‘X’ have an
impact on the demand for ‘Y’ and vice versa. In terms of marginal revenue;

MRX = dTRX/dQX + d TRY/dQX (1)

and

MRY = d TRY/dQY + d TRX/dQY (2)

Equation (1) indicates that marginal revenue associated with changes in the quantity of X can be separated into
two components:

dTRX/dQX= changes in revenue for good X resulting from a one unit increase in the sales of good X.

d TRY/dQx= demand interdependency. It indicates the change in revenue from the sale of good Y caused by a
one unit increase in sales of good X.

For the equation (2)

dTRY/dQY= changes in revenue for good Y resulting from a one unit increase in the sales of good Y.

d TRX/dQY= demand interdependency. It indicates the change in revenue from the sale of good X caused by a
one unit increase in sales of good Y.

The signs of interdependency terms dTRY/dQX and dTRX/dQY, depend on the nature of the relationship between
X and Y. If the two goods are complements, both terms will be positive, and increased sales of one good will
stimulate sales for the other. Conversely, if the goods are substitutes, the two terms will be negative because
additional sales of one good reduce sales of the other.

Clearly, the firm must consider demand interdependencies in order to make optimal pricing and output
decisions. Assume that goods X and Y are complements. In determining the profit maximizing rate of output for

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good X, if the effect of sales on X on the demand for Y is not considered, output of X would be increased only
until dTRY/dQX equals the marginal cost of producing X.

dTRX/dQX understates the actual incremental revenue generated by selling an additional unit of X. Specifically,
revenue is also affected by dTRY/dQX, which is positive, if the two goods are complements. Thus, when demand
interdependence is taken into account, profit maximization requires a greater rate of output from good X. In
fact, output of X should be increased until dTRX/dQX + d TRY/dQX = MCX

Where, MCX is the additional cost incurred by the firm in producing an additional unit of good X Similarly, if
the goods that are substitutes, it can be easily shown that ignoring the demand interdependency will cause too
many units of output to be produced.

Joint products produced in variable proportions

Firms can even vary the proportion in which joint products are created. When the proportions of joint output
can be varied, it is possible to construct separate marginal cost relations for each product. The firm maximizes
profit by operating at the output level where the marginal cost of producing each joint product just equals the
marginal revenue it generates. The profit maximizing combination of joint products A and B for example,
occurs at the output level where MR A =MC B andMR B =MC B . Common costs are expenses necessary for the
manufacture of a joint product. Common costs of production- raw material and equipment costs, management
costs and other overhead expenses

Joint products produced in fixed proportions

Products that must be produced in fixed proportions should be considered as a package or bundle of output.
Optimal price and output determination for output produced in fixed proportions requires analysis of the
relation between marginal revenue and marginal cost for the combined output package. As long as the sum of
marginal revenues obtained from all by-products is greater than the marginal cost of production, the firm gains
by expanding output.

Calculating the profit maximizing prices for joint products

A rancher sells hides and beef. The two goods are assumed to be jointly produced in fixed proportions. The
marginal cost equation for the beef-hide product package is given by MC = 30 + 5Q

The demand and marginal revenue equations for the two products are:

BEEF HIDES

P = 60 – 1Q P = 80-2Q

MR = 60- 2Q MR = 80 – 4Q

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What prices should be charged for beef and hide? How many units of the product package should be produced?

Solution:
Summing the two marginal revenue equations gives;

MRT= 140 – 6Q

The optimal quantity is determined by equating MRT and MC and solving for Q. Thus,

140 – 6Q = 30 + 5Q

140-30 = 5Q + 6Q

110 = 11Q

Q = 10

Substituting Q = 10 units into the demand curve yields a price of $50 for beef and $60 for hides. Before
concluding that these prices maximize profits, the marginal revenue at this output rate should be computed for
each product to assure that neither is negative. Substituting Q = 10 units into the marginal revenue equations
gives $40 for each good. Because both marginal revenues are positive, the prices given maximize profits. If
marginal product for either product is negative, the quantity sold at that product should be reduced to the point
where marginal revenue equal zero.

Joint products without excess by-product

The Vancouver Paper Company, located in Vancouver, British Columbia, produces newsprint and packaging
materials in a fixed 1:1 ratio, or 1 ton of packaging materials per 1 ton of newsprint. These two products, A
(newsprint) and B (packaging materials), are produced in equal quantities because newsprint production leaves
scrap by-product that is useful only in the production of lower grade packaging materials. The total and
marginal cost functions for Vancouver can be written as;

TC = 2,000,000 + 50Q + 0.01Q2

MC = ΔTC / ΔQ = 50 + 0.02Q
Where, Q is a composite package or bundle of output consisting of 1 ton of product A and 1 ton of product B.
Given current market conditions, demand and marginal revenue curves for each product are as follows;

Newsprint Packaging materials

PA = 400- 0.01QA PB = 350- 0.015QB

MR A = ΔTR A / ΔQ A = 400- 0.02Q MR B = Δ TRB / ΔQ B = 350- 0.03Q

A B

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TR = TRA + TRB

= PAQA + PBQB

Substituting for PA and PB results in the total revenue function;

TR = (400- 0.01QA)QA + (350- 0.015QB) QB

= 400QA – 0.01Q2A+ 350QB – 0.015Q2B

Because one unit of A and one unit of B are contained in each unit of Q, QA= QB = Q

This allows substitution of Q for QA and QB to develop a revenue function in terms of Q, the unit of production;

TR = 400Q– 0.01Q2 + 350Q– 0.015Q2

= 750Q – 0.025Q2

This total revenue function assumes that all quantities of product A and product B produced are also sold. It
assumes no dumping or withholding from the market for either product. The marginal revenues of both products
are positive at the profit maximizing output level.

Profit maximizing output level, MR =MC

750- 0.05Q = 50 + 0.02Q

700 = 0.07Q

Q = 10,000 units

At the activity level of 10,000 units, the marginal revenues for each product are positive:

MRA = 400- 0.02QA

= 400 – 0.02(10,000)

= 400 – 200 = $200

MRB = 350- 0.03QB

= 350 – 0.03(10,000)

350 – 300 = $50

Each product makes a positive contribution towards covering the marginal cost of production where,

MC = 50 + 0.02Q

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= 50 + 0.02(10,000)

50 + 200 = $250

MR = MRA + MRB = MC = 250

Prices for each product and total profits for Vancouver can be calculated from the demand and the total profit
functions;

PA = 400- 0.01QA

= 400- 0.01 (10,000)

= 400- 100 = 300

PB = 350- 0.015QB

= 350 – 0.015(10,000)

= 350 – 150 = 200

Profit, ∏ = PAQA + PBQB – TC

= 300(10,000) + 200(10,000) - 2,000,000 + 50Q + 0.01Q2

= 300(10,000) + 200(10,000) - 2,000,000 + 50(10,000) + 0.01(10,000)2

= $1,500,000

Conclusion:

Vancouver should produce 10,000 units of output and sell the resulting 10,000 units of product A at a price
$300 per ton and 10,000 units of product B at a price of $200 per ton. An optimum profit of 1.5 million is
earned at this activity level.

Joint production with excess by-product (Dumping)

Suppose that an economic recession causes the demand for product B (packaging materials) to fall dramatically,
while the demand for product A (newsprint) and marginal cost conditions hold steady. Assume new demand
and marginal revenue relations for product B of,
1
B
P = 290 – 0.02QB
1 1
B B
MR = Δ TR / ΔQ B = 290 – 0.04QB
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A dramatically lower price of $90 per ton (290- 0.02 x 10000) is now required to sell 10,000 units of product B.
This price and activity level is suboptimal.

Assuming that all output is sold, the new marginal revenue curve for Q is;

MR = MRA + MR1B

= 400- 0.02QA + 290 – 0.04QB

= 690 - 0.06Q

If all production is sold, the profit maximizing level for output is found by setting MR = MC and solving for Q;

MR = MC

690 - 0.06Q = 50 + 0.02Q

640 = 0.08Q

Q = 8000 units

At Q = 8000 the sum of the marginal revenues derived from both by-products and the marginal cost of
producing the combined output package each equal $210, because

MR = 690 - 0.06Q = 690 – (0.06 x 8000) = 690- 480 = $210

MC = 50 + 0.02Q = 50 + (0.02 x 8000) = 50 + 160 = $210

However, the marginal revenue of product B is no longer positive;

MRA = 400- 0.02QA = 400 – (0.02 x 8000) = 400 – 160 = $240

1 1
B B
MR = Δ TR / ΔQ B = 290 – 0.04QB = 290- (0.04 x 8000) = 290 -320 = $-30

Even though MR=MC= $210, the marginal revenue of product B is negative at 8000 units. This means that the
price reduction necessary to sell the last unit of product B causes Vancouver’s total revenue to decline by $30.
Rather than sell product B at such unfavorable terms, Vancouver would prefer to withhold some from the
market place. It would be profitable for the company to expand production of Q just to increase sales of product
A even if it had to destroy or otherwise withhold from the market the unavoidable added production of product
B.

Under these circumstances, set the marginal revenue of product A, the only product sold at margin, equal to the
marginal cost of production to find the profit maximizing activity level.

MRA = MC

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400- 0.02Q = 50 + 0.02Q

350 = 0.04Q

Q = 8750 units

Under these circumstances Vancouver should produce 8750 units of Q = Q A = QB. Because this activity level is
based on the assumption that only product A is sold at the margin and that the marginal revenue of product A
covers all marginal production costs, the effective marginal cost of product B is zero. As long as production is
sufficient to provide 8750 units of product A, 8750 units of product B are also produced without any additional
cost.

With an effective marginal cost of zero for product B, its contribution to firm’s profit is maximized by setting
the marginal revenue of product B equal to zero (its effective marginal cost).
1
B
MR = MC B

290 – 0.04 QB = 0

0.04QB = 290

QB = 7250

Whereas a total of 8750 units of Q should be produced, only 7250 units of product B will be sold. The
remaining 1500 units of QB must be destroyed or otherwise withheld from the market. Optimal prices and
maximum total profit for Vancouver are as follows;

PA = 400- 0.01QA

= 400 – (0.01 x 8750) = 400- 87.5 = $312.50

1
B
P = 290 – 0.02QB

= 290 – (0.02 x 7250) = 290- 145 = $145

Profit, ∏ = PAQA + P1BQB – TC

= (312.50 x 8750) + (145 + 7250) - 2,000,000 + 50(8750) + 0.01(8750)2

= $582, 500

No other price/output combination has the potential to generate as large a profit for Vancouver.

Fully distributed versus Incremental cost pricing

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Some costs are clearly related to the provision of a particular product or service. For example, meters on
homes are there for the sole purpose of measuring the amount of electricity used in the house. Electricity for
residential users is transmitted to urban areas over such lines. These same facilities are also used to serve
industrial and commercial customers. For an electric utility expenses associated with high voltage transmission
are referred to as common costs. Because the facilities are necessary to provide service to each class of
customers, any allocation of these common costs is essentially arbitrary.

Many businesses make extensive use of a practice called distributive cost pricing. This approach allocates a
portion of the firm’s common costs to each product or service. That is, common costs are distributed among the
products and services of the firm. Then the price of each is set so that covers the designated portion of common
costs plus costs that are directly related to the provision of the product or service. A scheme that allocates a
small portion of common costs to a product will result in a lower price and greater quantity demanded for that
product than will a method that apportions a larger fraction of such costs to the product.

Example:

A firm provides two services, temporary secretarial help and data processing. The firm has $10 million of
common costs that must be paid even if neither service is provided. Provision of the first service is very labour
intensive and 80% of all labor costs involve the secretarial workers. In contrast, data processing is capital
intensive, 80% of all capital costs involve this service.

The firm’s management decides to base prices on fully distributed costs. Two allocation schemes are proposed.
The first is to apportion common costs on the basis of labor costs resulting from each service. The second
approach allocates common costs in proportion to the amount of capital investment that can be attributed
directly to supplying each service.

Reference:

Lila J. Truett and Dale B. Truett (2001). Managerial Economics Analysis, Problems and Cases, 7 th
Ed, South-Western College Publishing
Paul G. Keat and Philip K.Y. Young (1996). Managerial Economics: Economic Tools for Today’s
Decision Makers, 2nd Ed, Prentice Hall, New Jersey
Nick, W. (2005). Managerial Economics, A problem solving approach, Cambridge University
press, New York
Thomas, J.W. (2003). Managerial Economics, theory and practice, academic press

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